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Notebooks Without Wide Margins


For the past few years, PC makers have relied heavily on one segment to drive earnings: notebook computers. Indeed, customers' love of portability has created a roaring engine in an otherwise dismal industry. "Notebooks are nicely profitable," Hewlett-Packard (HPQ) CEO Mark V. Hurd told analysts this month, after announcing HP's best PC results since 2001.

But how long will the good times last? Many see signs that this $79 billion market may follow the same script as the once-lucrative desktop PC business. Even though Gartner Inc. expects notebook revenue growth to increase 15.9% this year, up from 14.5% in '04, it's expected to slow to 12.6% next year.

That's in part because prices are dropping fast. Already, PC makers are trying to woo buyers with no-frills laptops priced as low as $499, or $399 with rebates. And competition is heating up, with scrappy players such as Acer, Averatec, and Gateway clearly prepared to accept lower gross margins and make it up on volume. Roger D. Kay, president of EndPoint Technology Associates, figures operating profits on notebooks are still around 9%, vs. 5% for a desktop. "But when the bloodbath is over," he asks, "are notebook margins going to be any better than desktop margins? Probably, but not by much."

Blame a dangerous double whammy, says First Albany Corp. analyst Joel M. Wagonfeld. Not only are profit margins declining as makers run out of room to cut costs, but cheapo models are expected to drive most of the sales growth. That means even if margins stabilize, PC makers will realize even fewer dollars of profit per unit.

And with much of the global demand coming from price-sensitive emerging markets like China, the average notebook price is expected to fall to $717 in 2008, says IDC, down from $1,050 today. Assuming, as many analysts do, that operating margins will fall to 6%, that leaves a meager $50 profit. "Most of the growth is coming from less-profitable markets and lower-priced products," says Wagonfeld. "That's why, despite great unit growth, you have anemic revenue growth."

Meanwhile, players at the low end of the market are expected to keep the margin pressure cranked up. Having merged with low-price desktop maker eMachines Inc. (GTW), Gateway Inc. (GTW) is applying its thrifty ways to the notebook market. And Asian players willing to accept lousy margins for more share are muscling in. One is Averatec Inc., a three-year-old outfit based in Santa Ana, Calif., backed by the same Asian manufacturer, TriGem Computer Inc., that funded eMachines. Averatec President Saeed Shahbazi says the company already makes do with that miserly 6% operating margin on its notebooks, which are mostly aimed at the current sweet spot of the market: so-called "thin and light" machines costing around $1,000.

CORPORATE SLOWDOWN

Competition and falling prices aren't a fatal formula for PC makers as long as unit growth keeps pace. But many analysts fear growth is bound to slow at some point. While sales to consumers remain brisk, Leslie Fiering, an analyst with Gartner, says a three-year buying binge by corporations has started to slow. "The replacement cycle is tapering off," he adds. "And as demand comes down, not everyone is going to be able to maintain enough margin to remain viable."

PC makers say they're unfazed. They note that buyers tend to purchase plenty of high-margin add-ons, including service contracts, additional batteries, and docking stations. Moreover, there's still room to innovate and earn a premium from customers. Gateway this week announced a new theft-protection service that helps corporate IT managers locate lost or stolen laptops. HP's recently updated models have a feature that lets users play a CD or DVD without waiting for Windows to boot up.

Few expect an all-out price war this Christmas. That's due in part to shortages in certain components, which could limit production in the coming months, and price hikes on other parts. Still, there's little doubt that notebook profits are heading in the wrong direction. The only questions are how fast it's happening and how bad the bloodletting will be.

By Peter Burrows, with Louise Lee, in San Mateo, Calif., and Bruce Einhorn in Hong Kong


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